Q: We completed our 1031 exchange in September. Our renter has fallen on hardship due to the coronavirus pandemic and cannot afford the rent. Similarly, we are in a rental that is twice the amount of our mortgage. I know there is a relief for 45 and 180 days when a president has issued an emergency declaration. Does the coronavirus crisis count as such an emergency, or is there any change to the rules because of the coronavirus pandemic?
A: You are correct. The Internal Revenue Service has given temporary relief to people and entities that are in the process of going through a like-kind exchange (also known as a 1031 exchange).
A 1031 exchange is a method of selling a property and then buying a replacement property without having to pay any federal income taxes on any profits derived from the sale of the first property. In brief, the rules state that the properties must be of like kind: One type of real estate can be exchanged for another piece of real estate. Generally, all types of real estate properties are considered like kind for purposes of a 1031 exchange, so you could exchange a rental condo for a warehouse or strip center.
The law permitting a 1031 exchange is set up under the Internal Revenue Code Section 1031. Before you sell your first property, you need to set up an exchange with a company that specializes in 1031 exchanges. Once you close on the sale, you normally have no more than 45 days to identify one or more replacement properties, and you have no more than 180 days to close on one or more of those identified properties.
Here’s how the 1031 exchange process is supposed to work: Let’s say you sold your property on March 2. Under the standard 1031 exchange rules, you’d have until April 16 to identify your replacement property or properties, and you’d have to close on those new properties on or before Aug. 28. But let’s say because of the pandemic, you either can’t find replacement properties or restrictions have made it difficult to get to or view properties. Unless the IRS gives you a break, you’d lose the benefits of the 1031 exchange.
Those benefits include deferring the payment of any taxes on the profit from the sale of your property and delaying the repayment of any recapture of depreciation to which the IRS would be entitled. If you owned the original property for 20 years and have taken depreciation for those years, and your profit is huge, your tax liability to the IRS would be enormous. A 1031 exchange allows you to defer paying those taxes down the line; and it is possible you never have to pay them under certain conditions.
A few weeks ago, the IRS issued a change to the deadlines. Notice 2020-23, an emergency declaration by President Trump, has given relief in some deadlines for those with 1031 exchanges underway. If your exchange timeline requirements fall between April 1 and July 15, the deadline would be extended to July 15. In the example above, this would allow you until July 15 to identify properties to purchase.
It would help the buyer in this example to have until July 15 to identify the property and then close no later than Aug. 28. But you expressed concern regarding an exchange that was completed last year. You seem to imply that your tenant wants to move out, and you want to move into this property. We doubt you'll get any relief from the IRS for that issue from this new set of rules.
These rules can and might change at any time. Many tax-deferred exchange companies are lobbying for greater changes to these IRS 1031 legal requirements.
The IRS won’t look fondly on your converting an investment property into a personal residence. However, the tax hit may not be as bad as you think. Your intent when you undertook the sale and exchange of properties must have been for investment purposes, and you didn’t know that the coronavirus was coming, so we suspect that your tax return from last year would show the 1031 exchange and you’d have deferred the taxes on that sale.
If you convert the home to your residence and then sell the property, you probably won’t be able to use a 1031 exchange to defer any profit or taxes owed. At that time, your tax situation would be complicated, because you’d be selling the investment property and your home. You’d probably end up having to pay taxes on the investment side of your sale, but if the home was your principal residence, you might get some benefit from the $250,000 home-sale exclusion rule.
There are many tax implications; we’re giving you a small taste of what you might face going forward. For more information, you'll need to talk to an accountant, an enrolled agent, a tax adviser or a 1031 specialist to go over your situation.
Ilyce Glink is the author of “100 Questions Every First-Time Home Buyer Should Ask” (4th Edition). She is also the CEO of Best Money Moves, an app that employers provide to employees to measure and dial down financial stress. Samuel J. Tamkin is a Chicago-based real estate attorney. Contact Ilyce and Sam through her website, ThinkGlink.com.